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Disaggregating marketplace attitudes toward risk: a contingent-claim-based model

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  • Edwin Neave
  • Jun Yang

Abstract

With a view to providing economic interpretations of temporal changes in Risk-Neutral Probability Distributions (RNPDs), this article estimates RNPDs from option prices, then studies the expected excess returns on a fixed-strategy reference portfolio constructed from RNPD-defined contingent claims. It disaggregates the reference portfolio into an investment, an insurance and a certainty component, each containing one type of contingent claim (having positive, negative or zero expected excess return, respectively). The disaggregation provides a convenient way of operationalizing Markowitz's semi-variance measures, one for upside potential and one for downside risk. Our empirical tests show that the pricing of investment-oriented claims is related to both S&P index growth and volatility, but the pricing of insurance-oriented claims is related only to index volatility. Moreover, the relative importance of insurance earnings to total earnings appears principally to be related to volatility. Thus our analyses show that investment and insurance claims are priced differently in the marketplace, and the different pricing effects can be identified by disaggregating the reference portfolio returns.

Suggested Citation

  • Edwin Neave & Jun Yang, 2009. "Disaggregating marketplace attitudes toward risk: a contingent-claim-based model," Applied Financial Economics, Taylor & Francis Journals, vol. 19(9), pages 719-733.
    • Handle: RePEc:taf:apfiec:v:19:y:2009:i:9:p:719-733
    DOI: 10.1080/09603100801964412
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    1. Bhupinder Bahra, 1997. "Implied risk-neutral probability density functions from option prices: theory and application," Bank of England working papers 66, Bank of England.
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    Cited by:

    1. Sheng, Jiliang & Xu, Si & An, Yunbi & Yang, Jun, 2021. "Dynamic portfolio strategy by loss-averse fund managers facing performance-induced fund flows," International Review of Financial Analysis, Elsevier, vol. 73(C).

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